Impax Environmental Markets (IEM) offers exposure to mid- and small-cap companies the managers expect to profit from the transition to a more sustainable economy. The trust has performed very well relative to wider equity markets over the past five years – especially in share price terms.
The managers have a disciplined investment process which they believe has helped them cope with the huge shifts in equity markets seen over the past 12 months. Impax are growth investors but have a strong valuation overlay. At times this leaves them open to the risk that they may lag very strongly performing markets. During 2020 most trading activity was focussed on the second half of the year, with the team trimming companies that had hit price targets. This has set the trust up well on a relative basis since the November news of an effective COVID-19 vaccine.
Historical outperformance has been largely achieved by the portfolio delivering stronger underlying earnings growth relative to the wider index. For 2020, earnings declines were broadly in line with those of MSCI ACWI. However, the managers’ report having seen a positive outcome from Q4 earnings and a reversion to the portfolio’s premium growth expected in 2021.
Valuations have risen; IEM’s portfolio currently has an average P/E of 26x, representing a premium of 38% to the market, compared to a historic average premium of 20%. These higher valuations are a factor in the managers’ reluctance to employ gearing, and IEM has net gearing of c. 2.5% currently. The managers’ report that they remain mindful of the risks presented by higher valuations and are aiming to position IEM for defensive growth.
The Impax team are fundamental stock pickers that invest in growth companies. At the same time, they have a strong valuation overlay. At times, this leaves them open to the risk that they may lag very strongly performing markets by not having exposure to very popular stocks such as Tesla. However, we believe that in terms of generating consistent alpha, a valuation-led investment process is more likely to be repeatable through the cycle than trying to second guess the next ‘hot’ stock.
IEM invests in mid and small-cap companies in a niche that is becoming increasingly popular. As such, it represents a capacity-constrained strategy. The managers have been cautious in managing this capacity, and as such, the board have been issuing shares, but have had to agree to constraints on the number of shares issued. With c. £83m worth of shares available to be issued, this should prevent the premium from reaching the high levels of last year, which is good news for investors.
IEM offers an attractive package, which is reflected in the current premium to NAV of 3%. It is likely to complement other global growth portfolios, which has become apparent this year following the significant sell-off seen in technology stocks. There are short term risks present in the form of portfolio valuations being higher than historic averages. But, for long term investors, IEM remains a differentiated proposition to most global funds and trusts.
|Niche investment strategy which has come of age and performed strongly since the market bottom
||Portfolio trading on a higher premium to wider markets than historically
|Strong historic underlying earnings growth provides evidence of manager’s stock picking skills
||Exposure to industrials and cyclicals could leave IEM vulnerable to an economic slowdown
|Specialist, well-resourced manager
||Trading on a premium to NAV
Impax Environmental Markets (IEM) offers exposure to a range of mid and small-cap companies in a variety of sectors that are expected to profit from the transition to a more sustainable economy. Having launched in 2002, well ahead of much of the rest of the ESG and sustainability crowd, with the same investment thesis, the last few years has increasingly seen global investor attention focus on this area. As we discuss in the Performance section, the trust has performed very well relative to wider equity markets over the past five years – especially in share price terms where a discount to NAV has been replaced with a premium rating. At the same time, the underlying portfolio’s valuation premium has also expanded relative to global equities. IEM’s NAV has not been immune to the recent rotation towards value, but when we caught up with IEM’s manager Jon Forster recently, he said he welcomed some of the “froth” being blown off markets.
One of the trademarks of IEM is the consistency of the management team, which has comprised of Bruce Jenkyn-Jones and Jon Forster since launch, who have worked together for over 20 years. The managers have a disciplined investment process which they believe has helped them cope with the huge shifts in equity markets seen over the past 12 months. The team are growth investors, but have a strong valuation overlay. At times, this leaves them open to the risk that they may lag very strongly performing markets or do not have exposure to very popular momentum stocks such as Tesla. However, we believe that in terms of generating consistent alpha, a valuation-led investment process is more likely to be repeatable over a stock market cycle than trying to second guess the next ‘hot’ stock.
Over 2020, turnover has remained in line with the team’s long-term average, at c. 20%. Most trading activity we understand was focussed on the second half of the year, with the team trimming or selling companies that had hit price targets, and recycling into more attractively valued opportunities. In particular, we understand the exposure to renewables was reduced significantly, which has helped relative performance given the sector has underperformed subsequently. Indeed, so dramatic has been the share price selloffs in some companies that the team have started to add to holdings in the likes of EDP Renovaveis and Xinyi Solar, both having been a long-term feature in the portfolio but which were sold in the first half of 2020.
The team look for companies on a global basis that help mitigate or adapt to climate change. Investment ideas generally fall within four broad areas: new energy, water, waste/resource recovery, and sustainable food, agriculture, and forestry. The team aim to manage risk through diversification, and so within these broad areas, the trust has underlying exposure to many different sub-sectors, that we illustrate in the pie chart below.
As evidence of the fundamental stock-picking foundations of Impax’s investment approach, Jon and his team have a good track record of their companies delivering earnings growth ahead of wider markets. With many of the trust’s holdings now having reported for 2020 Jon observes that earnings declines were broadly in line with those of MSCI ACWI. However, the team report having seen a positive outcome from Q4 earnings and are optimistic in their view that they will see a reversion to the portfolio’s premium growth, expected in 2021. The portfolio has traditionally traded at a c. 20% valuation premium to the market in terms of valuations, reflecting historically higher growth. However, IEM’s portfolio currently has an average P/E of 26x, representing a premium of c. 38% to comparative indices. This is lower than it was during parts of last year, but higher valuations are a factor in the manager’s reluctance to employ gearing, and cautious stance (the portfolio has a net gearing of c. 2.5% currently).
The team have long held the belief that a consistent tailwind to the strategy will be the regulatory ‘ratchet’. At points, over recent years (President Trump’s election etc) the tailwind has seemed to ebb. However, latterly things have started to pick up again, with President Biden signing the US back up to the Paris Climate Agreement, as well as appointing well regarded and credible heavyweights to senior positions in his environmental team. In China, the team believe that the latest five-year plan, whilst on the surface didn’t make the progress that some environmentalists hoped, will actually be positive for the strategy. The team believe that instead of a directives-based approach, the Chinese government is trying to develop a local carbon market, which will push regional governments to take a market-based approach to carbon reduction. Within the EU, the team expect stimulus to be directed at environmental and de-carbonisation projects, and that this will start hitting the ground at the end of this year (2021).
For many Americans, the need to diversify their energy mix has been recently highlighted by the recent Texas power crisis which pointed to an over-reliance on natural gas. We note that exposure to the US has been gently nudging up, no doubt a reflection of stock-specific opportunities rather than a macro call by the managers. It now stands at 47% of NAV (31/01/2021), having been 44% as at 31/10/2020. Recognising the potential for inflation, Jon and the team point to their overweight position in industrials compared to ACWI and a preference for companies with pricing power and earnings momentum. The team observed that the utilities they own also stand to be in a good position should inflation take off, with inflation built into their pricing structures.
As we mentioned above, the team have a disciplined investment process based on fundamental stock picking with the aim of holding companies over the long term. The top ten is full of familiar names to IEM followers, as we illustrate below. Turnover has been broadly in-line with historical averages, but several holdings have been sold on valuation grounds, such as Zhuzhou CRRC, the Chinese supplier of technology for railways. The team continue to look for software businesses, with Descartes one example that the team have bought. The company helps customers make efficiency savings in logistics. The Impax team observe that their investment discipline has meant the portfolio has been defensive, and their valuation framework means they are not usually exposed to ‘hot’ areas such as electric vehicles, which has helped them avoid the worst effects of the recent technology sell-off.
TOP TEN HOLDINGS
|American Water Works
Source: Impax, as at 28/02/2021
In terms of outlook, the team report that they remain mindful of the risks presented by higher valuations and are aiming to position IEM for defensive growth. That said, to any extent that earnings disappoint, then this presents risks for IEM’s portfolio which is currently being valued significantly higher than long term averages. On the other hand, depending on how much political rhetoric on accelerating the move to ‘net-zero’ turns into reality, there is a chance that long term earnings for the underlying portfolio will continue to outperform the wider market and justify the valuation premium.
We understand that the board of IEM sees gearing as a positive feature of investment trusts and generally encourages the manager to use it. The managers have full discretion on a tactical basis to employ gearing up to a level of 10% of NAV. As the graph below shows, gearing has been employed by the manager, but more recently has become less of a feature. This is in part reflective of the manager’s valuation led approach (see Portfolio), and general caution on the overall level of valuations for the companies in the universe.
IEM has elements of structural gearing, fixed to 2023 and short-term facilities. The structural gearing is represented by two loans in different currencies of £15m and US$20m, with interest rates on the loans of 2.910% and 4.504% per annum, respectively. IEM’s revolving credit facility of £20m is fully drawn down, with net gearing currently at 2.5% (as at 28/02/2021).
Over the past five years, IEM has seen strong returns relative to broader equity markets. It is worth noting that the AIC Global sector in the graph below is the weighted average NAV return, to which Scottish Mortgage is a significant contributor (its performance has been exceptionally strong, largely thanks to a large stake in Tesla, a stock which is in the IEM universe but has always been too expensive and lacking good enough governance for the managers to consider). As we examine in more detail further below, the market ructions since the pandemic hit have, in our view, illustrated some interesting characteristics of the portfolio.
Past performance is not a reliable guide to future returns
Looking at calendar year returns, the graph below shows that IEM has outperformed the MSCI ACWI in six out of the past nine years. Aside from highlighting the strong outperformance over both of the last two years, we believe this graph serves to highlight the fact that returns from the trust can deviate quite significantly (both positive and negative) from the broader index. We understand that historical outperformance has been largely achieved by the portfolio delivering stronger underlying earnings growth relative to the wider index. However, as we discuss in the Portfolio section, it is clear that, whilst earnings continue to grow ahead of the benchmark, valuations have risen significantly.
DISCRETE CALENDAR YEAR NAV TR PERFORMANCE
Past performance is not a reliable guide to future returns
The graph below, showing performance from when the COVID-19 pandemic first started to affect stock markets, illustrates an important point. As the market fell, exposure to industrials and cyclicals, as well as relatively low exposure to healthcare and the US dollar, meant that IEM underperformed the index and global peers. As the recovery gained momentum from the second quarter onwards, the manager’s disciplined investment process allowed the trust to regain lost ground and more, and, as we highlight in the graph above, meant the trust considerably outperformed over the year as a whole. That said, it has underperformed the most strongly performing trusts and funds, which have typically had a significant bias to large-cap technology stocks and stocks which one might consider more ‘speculative growth’ opportunities. However, as is suggested in the graph below, but we zoom into further below, it is this that has allowed the trust to outperform the same group of trusts since news broke of an effective vaccine.
NAV TOTAL RETURNS SINCE MARKET PEAK in Q1 2020
Past performance is not a reliable guide to future returns
Since the announcement of an effective vaccine, stock markets started to see elements of a rotation away from ‘Covid-19-winners’ towards more cyclical names. This was then compounded during February by inflation and interest rate expectations in the US rising, which saw technology and other high growth names suffer very significant falls. The graph below shows how IEM has delivered a strong performance on a relative basis over this period. We attribute this to the defensive growth bias in the portfolio, but also the managers remaining disciplined and sticking with their valuation led approach. This, we would observe, has led them to avoid more speculative areas of the market and sell companies that hit price targets, recycling capital into what they see as opportunities offering better value.
NAV Performance sINCE VACCINE ANNOUNCEMENT
Past performance is not a reliable guide to future returns
IEM’s primary objective is to achieve capital growth. Dividends are not a priority for the manager, nor the board. However, the board intends to pay out substantially all the trust’s earnings by way of dividends. Given that the majority of holdings in the portfolio invest excess cash back into their own businesses to fund future growth, rather than paying dividends, the portfolio yield is relatively low.
In order to minimise the effect of dilution from issuing new shares, the board have adopted a policy of paying an interim and final dividend over the year. The first interim of the current financial year (1.3p per share) had an ex-dividend date of 6 August 2020. The board declared a second interim dividend (1.0p per share) which had an ex-dividend date of 18 February 2021 having cautioned that the total dividend may be lower than the 3p per share paid for the 2018 and 2019 financial years. Based on the historic dividend, IEM’s shares yield 0.5% at the current price. We continue to believe that investors should not see dividends as a key feature of the investment proposition.
Impax Asset Management was established in 1998 and now manages £25.2bn, as at 31 December 2020, across a range of strategies. Bruce Jenkyn-Jones is co-head of the listed equities side of Impax having joined in 1999. Jon Forster joined the firm in 2000, and together they have overall responsibility for IEM. Ian Simm, a co-founder of Impax, chairs the investment committee.
The trust has significant research resources, with 24 investment professionals focussed on the portfolio and its core themes. The group emphasise this aspect in its marketing effort, as a key advantage in comparison to broader ‘generalist’ trusts investing in the same area. The team meet once a week to discuss stock ideas for the portfolio and update their macro views once a quarter.
2020 has seen a huge level of interest in sustainable investments, but, as the graph below shows, this marks a continuation of a longer running change in sentiment. Historically, and for a number of years, IEM traded at a wide discount to NAV. All of this started to change in 2018, and the discount has given way to a (sometimes substantial) premium to NAV. IEM invests in mid and small-cap companies, and so it represents a capacity-constrained strategy. The managers have been cautious in managing this capacity, and as such, whilst the board have been issuing shares it has had to agree to constraints on the number of shares issued. The company had a total of 26m shares approved for issuance at a general meeting held in January, and with subsequent issuance now has c. 17m shares left available to issue. At current prices, this equates to c. £75m, and so, for the time being should prevent the premium from reaching the very high levels approaching 10% last year.
In our view, there are never winners when premiums expand to this sort of level (click here to view), and as such this is good news for investors. The growing popularity of sustainability as an investment theme, combined with growing recognition of Impax Asset Management as a leader in this space with a depth of experience not found in many other managers, means that shares will likely continue to be in demand. As with any trust on a significant premium, we would emphasize caution in pushing the share price too high. It is worth remembering that, during volatile periods for markets, the discount could widen out over short periods which might be exacerbated by a reversion of extended relative valuations in the underlying portfolio. In this regard IEM board has committed to using its powers “to issue and buy back shares in a proactive manner, with the aim of seeing the shares, in normal market conditions, trading close to net asset value on a consistent and long-term basis”. IEM has a continuation vote every three years, the most recent having taken place in May 2019.
DISCOUNT TO NAV
IEM has a tiered management fee which results in a blended fee which we estimate at 0.75% of NAV (currently £1.16bn). This fee is made up of 0.9% payable for the first £475m of net assets, with anything over this charged at 0.65%. As the trust grows, shareholders benefit from a reduction in overall fees. The ongoing charges figure calculated along AIC guidelines, published in the latest factsheet (28/02/2021), is 0.95%. The OCF compares with the simple (i.e. unweighted) average for the AIC’s Global Investment Trust sector of 0.65%. The KID RIY cost is 1.33%, made up of ongoing costs of 1.12% and transaction costs of 0.21%.
Impax sees themselves as growth investors concentrated on key themes emerging from the transition to a more sustainable economy, where ESG analysis helps identify quality and risk. To some, this will represent a practical expression of what some people view as a ‘classic’ ESG theme. At the same time, IEM’s mandate has few prescriptive restrictions as to how the portfolio is made up; other than the necessity for investee companies to have more than 50% of their revenues deriving from what Impax Asset Management calls ‘environmental markets’ (water, energy, waste management and the food/agriculture sectors). In focussing on these sectors, the team’s only objective is to deliver strong financial returns and thus IEM is not an explicitly ESG trust, despite its dedication to sustainable investing.
With regards to ESG, the Impax team have long held it as a research tool that helps them identify quality and risk. So, having an accurate understanding of environmental, social and governance risks is one of the key contributors towards finding successful long-term investments. In their opinion, quality businesses help to future-proof themselves by having good ESG processes embedded within every aspect of their operations. This is backed up by the Morningstar Sustainability rating of the portfolio (which measures the output of the manager’s investment process) as “above average” when compared to the broader Morningstar Ecology sector. It should be noted that the mid and small-cap companies which make up IEM’s portfolio often under-report their ESG credentials when compared to the larger cap stocks. This has the unfortunate tendency to bias the quantitative ESG ratings of these company’s downward and may not fully reflect the ESG credentials of the portfolio.
In this respect, we believe IEM offers a differentiated exposure for ESG investors. In particular, we believe that the long experience and singular focus of the team put investors in good stead to avoid those areas most affected by hype and extended expectations. The managers highlight the current excitement from many ‘ESG-themed’ investors towards those companies engaged in developing hydrogen as a fuel or energy store. The Impax team remain unconvinced, having experienced the same recurring theme in previous cycles and having found no fundamental changes to the technology.
We continue to believe IEM could be considered for any ESG portfolio. At the same time (given the specialist nature of the managers’ focus) it would likely complement many traditional portfolios too.